Revisiting Agency Theory
The contractual problem of Agent and Principal
In 1973 Ross developed the Agency Theory, which describes the Principal-Agent problem. This problem designates a set of situations in the relationship between Principal and Agent. Both need to collaborate, although the Principal is in principle the one originating it. The principal requires an action by the Agent. In this sense, a typical situation is the relationship between the capitalist and his or her employee, although the latter can be employed as a manager. Thus, this is also typically cited case between shareholders and company direction. In this contractual relationship, there is an imperfect (asymmetric) information and the interests of both sides can be divergent.
When this problem is approached from the Agency Theory perspective, it is implicitly assumed that only the agent tends to adopt opportunistic behaviours in the contractual relationship. However, reality shows the opposite, and it is even more so in matrix-type organizations, where the role assumed in a contractual relationship varies according to the situation.
The Principal-Agent conflict occurs in many everyday situations, in relations among two or more parties, when each of them tries to maximize its benefits or take more than it would result from a fair relationship. Of course, the definition of what is considered fair varies according to each society and its culture, evolving over time according to its progress and the normalization of certain practices, which in other times would be considered inappropriate. Unfortunately, this evolution of what is understood as just and justifiable does not always go in the right direction, that is, advancing collective intelligence from the holistic point of view, considering the overall society sustainability.
The main dilemma is presented in the form of asymmetry of information, but above all of the vision. Lack of vision is indeed even worse because it implies blindness, with consequences that may be positive in the short term but negative or counterproductive in the medium or long term. Information asymmetry takes several forms, three of which are considered key (see figure below). Just to emphasize that they are closely related and often mutually reinforcing each other.
Adverse selection occurs when one of the contractual parties, due to its position within the relationship and its own characteristics unknown to the other side, can take advantage of it. The case of insurance is usually cited as an example, when a person that does not take care of its health is more likely to acquire health insurance. Hence, the risk assumed by the insurer is higher compared to the general health statistics of the population. On the other hand, companies can try to manipulate their consumers through ‘captology’ practices that can be harmful for their lives quality.
The signaling effect takes place when one of the contract participants tries to signal characteristics that will disproportionately benefit him or her during the development of a relationship. An example could be the contract between the employer and employee, when the employee presents only his positive qualities, without showing the negative ones. Knowing this, the employer will tend to pay less, assuming that the employee will also display negative characteristics in the performance of their work, that were not pronounced at the time of hiring. To avoid this, employees must signal their ability and predisposition through the acquisition of educational levels that demonstrate their knowledge and positive attitude. On the other hand, companies can be signaling themselves through different badges, as the best place to work, for instance.
Moral hazard includes an opportunistic attitude when one contracting party seeks its benefit at the expense of the other. Following on with the insurance example, it would be the case when a person with health insurance does not take care of itself, assuming that in case of sickness the insurance will need to cover the possible issues.
Agency Theory proposes a planning, coordination and control model, which is applied to the architecture and management of organizations, proposing mechanisms for aligning the Principal-Agent interests and limiting the dilemmas they are to face.
This contractual approach aims to transform itself into a planning, coordination and control model, applied to the architecture and management of organizations. It proposes mechanisms for aligning the Principal-Agent interests and limiting the dilemmas they are to face. They start from the challenge of trying to elucidate and solve the dilemma that originates in differences of interests. In order to align these divergent interests, this approach proposes a series of alignment mechanisms. These mechanisms are focused almost exclusively on achieving degrees of loyalty and compliance from the Agent, although they must be appropriately used also by the Principal. Thus, the flow of the relationship should also be studied in the opposite direction. It is so, perhaps because a role change is foreseen a posteriori, in higher level loops. However, many times these loops are not structured sufficiently or efficiently.
Control systems serve to discipline the divergent interests that may arise, reducing the probability of opportunistic behavior or entrenchment through “supervision” and monitoring, in principle of both contractual parties. In order to maintain discipline, both internal and external control tools and mechanisms are applied systematically and continuously. These systems are in a continuous evolution, also taking into account the current evolution from the disciplinary society perspective that employs mainly physical control and imposition from the outside to the control society with efficiency indicators and internalized imposition assumed by the controlled subject. For example, physical punishment is not applied to school students, it is rather an average note that allows them or not to later access higher levels of studies. Similarly, in lines with the virtualization of the world of work, the physical presence for a certain period of time (working hours) is not as relevant as the achievement of the objectives set by the company.
Regulatory frameworks involve the institutional (legal, political and regulatory) mechanisms that adequately complement the control mechanisms. However, as demonstrated by several trust crisis, existing regulations tend to be insufficient or what is even worse, in many cases they are inadequate in their approaches and in their areas of control, and they are clearly exceeded by the real-life events. See for example, the case of the last financial crisis.
The exercise of market discipline would imply the existence of choice options that allow limiting and excluding or expelling opportunists, both on the Principal and Agent side. Of course, in the labor market with a shortage of work, the choice on the part of the agents is limited and leads to the assumption of harmful work contracts that in the long-term can harm the society as a whole, namely by polarizing it. The law of supply and demand can lead in this sense to the abuse of position, causing misguided increases in inequality in the short term and violent social conflicts that are pernicious to society in the medium term.
Compensation systems are widely employed in the arena of organizational science and business practices. While control systems are associated with negative punishment measures, compensation systems in principle would imply a positive reinforcement, although it is not always the case. Hence, different measures are cited, such as the application of a remuneration that incorporates variable elements, an evaluation of the results, a systematic evaluation of performance, a professional development system, concrete possibilities of expanding personal relationships, job security, expansion of tasks and responsibilities, increased learning and / or training opportunities, participation in decision-making, reputation, etc.
The Principal-Agent approach in the vast majority of cases, although not always, presupposes the existence of groups on both sides. Their size and composition are relevant, as well as their negotiation power and means at their disposal. Diversity and the search for synergies seem to be the key characteristics for collective intelligence success in this field.
Finally, there is the need for separation of roles and functions to avoid, for example, dual role issues that would allow the realization of particular agendas of some party that can be detrimental to the organization as a whole. The SOX or Sarbanes Oxley Law would be one of the ways to face these types of dilemmas.
Like any model, the Agency Theory should not remain unchanged in face of the evolution of society. Its premises and conclusions are embedded in the organization of companies, administrations, markets and society in general. The Agency Theory needs a thorough revision, focusing on opportunistic attitudes and activities of the Agent as well as the Principal. Without this, it is risky to think of a new social contract, and of the development of the collective intelligence of a society that aspires to sustainability.
Authors:
Renata Kubus: ResearchGate, LinkedIn
María Jesús Rosado García: LinkedIn
To check the Spanish version of the article, click here.
